Evaluation of the appropriateness of the treatments in Carter’s 2015 financial statements
Treatment of exclusive rights
Carter capitalised the amount paid for exclusive distribution rights. Distribution rights are intangible assets. In this case, the asset is not internally generated hence it should be capitalised in the year the cost is incurred. If the asset has a definite useful life, it should be amortised over the useful life. When an intangible asset is acquired, its reasonable useful life should be estimated to determine the amortization expense. However, an intangible asset whose useful life is indefinite shall not be subjected to amortization. Instead, it shall be tested for impairment and any losses recognised in the income statement. Impairment tests should be conducted until the time when the asset’s useful life is determined to be no longer indefinite. In this case, the lifespan of the exclusive distribution rights is unknown. Carter should have tested for its impairment and recognise any losses in the income statement. Since no amortization was charged and Carter did not test for impairment, the net income may have been overstated. The inclusion of impairment loss or amortization would reduce the net income reported.
Carter’s recognition of revenue when a customer signs up for the program is also wrong. ASC 600 requires that revenues be recognised when realizable and when earned (Flood 620). In this case, the revenues are realizable since the contracts are non-cancellable. However, the standard requires that revenues from non-cancellable contracts can only be considered an outright sale if the good is delivered or service is already performed and there are no remaining significant obligations. Carter has a remaining significant obligation to deliver the video game to the customers. The certificate issued is not the performance of Carter’s part of the contract but a proof of the contract. The revenue will only be earned when Carter delivers the video games (Flood 620). Besides, Carter pays the cost per copy is payable and recognised when the manufacturer delivers the video game to the store. Carter should recognise the revenue in the same period as the cost per copy to comply with the matching principle. Therefore, the revenue should not be recognised. The net income is overstated and an adjusting entry should be made to reduce revenue and report the cash received from customers as unearned revenue.
Service contracts
Revenues from service contracts should not be recognised upfront as Carter did. There are still outstanding performance obligations on the part of Carter. Although cash is received upfront, it should be reported as unearned service revenue. The revenue should be recognised over the term of the contract (Flood 640). Therefore, only revenues for the first five months of the contracts should be recognised. For the one-year contract, $50,000 (5/12 months × $300 × 400 contracts) should be recognised. For the two-year contracts, only $62,500 (5/12 months × $500 × 300 contracts) should be recognised. Therefore, the net income is overstated and should be reduced by a total of $157,500. Besides, the contingent liability for contract cancellation should be recognised since it is probable.
Fully depreciated asset
The entry for the purchase of the asset was wrongly entered in 2011. Thus, an adjusting entry should be made to the retained earnings. Retained earnings balance is increased by the cost of the asset initially expensed and reduced by the depreciation expense for the four years. The asset must be included in total assets with its full cost and accumulated depreciation even though its net book value is zero. However, this adjustment does not affect last year’s net income hence is irrelevant in the determination of the price to pay.
Carter’s salary
Dividends are not considered as expenses of the company. Thus, Carter’s decision to receive dividends instead of salaries increased the firm’s net income reported. This could amount to earnings management to report a higher net income to increase the price paid for the business. In this case, the net income for the year is overstated by $125,000. Therefore, past salary of $125,000 should be included in the income statement to determine the firm’s actual net income.
The non-interest bearing note should be included in the company’s liabilities. However, it will not affect the net income reported hence it is not material in the determination of the acquisition price of the business. The cottage Lake Muskoka purchased using the funds received is not included in the company’s financial statements.
Advertising cost
The advertising campaign can be considered as a direct-response advertising. It was targeted at particular customers (city residents) and was to promote the company for the holiday season. Carter ran the campaign until just before the holidays. Besides, the responses of customers during the holidays can be documented and considered to have resulted from the campaign. Therefore, Carter was right to capitalise the advertising cost. The cost is amortized over twelve months hence amortization expense for the three months to December 31 should be recognised. Thus, the amortization expense of $29,167 should be recorded in the income statement for the year ended December 31, 2015.
Works cited
Flood, Joanne M. Wiley GAAP 2016: Interpretation And Application Of Generally Accepted Accounting Principles. New York: John Wiley & Sons, 2015. Print.
